Collective DC Mythbusters

March 2020 Collective DC Mythbusters

Introduction

Following the announcement in the Queen’s Speech that the Government proposed legislation to permit the operation of Collective Defined Contribution (CDC) plans, there has been a positive deluge of articles criticising these plans — before they have even started! Many of these criticisms repeat popular misconceptions about how CDC plans operate, many assume they are doomed to repeat mistakes from history, most of the comments are from an uninformed or biased position (and none that we have seen have undertaken any modelling of potential outcomes) and many have obvious ulterior commercial motives. The publication of the Pensions Scheme Bill (the Bill) on 26 June 2014 addressed how the government proposed to deal with a number of the myths and misconceptions about how CDC plans would operate. This article sets out a compilation of the most common accusations against CDC plans — and sets out the truth of the matter. CDC plans offer the potential for better, more reliable pensions outcomes for many UK employees — for the sake of these employees, we will continue to argue in favour of CDC plans.

Aon In conjunction with the Friends of CDC Mythbusters The Top Ten

“CDC plans are just ‘Ponzi con-tricks’. CDC requires Myth 1. young members to sponsor old. There is nobody to pay for CDC wind-up. CDC won’t offer exit routes for employers and employees.”

The accusation here is that CDC The first point to note is that if There will still be a number of market plans need to last forever, with a any individual CDC plan were to cycles to make any adjustments, continual flow of new entrants, in terminate, it would probably be and so the smoothing mechanism order to sustain the risk-sharing and encouraged to merge with another can operate to the advantage of risk-pooling underlying the plans. open CDC plan. Encouraging scheme the remaining members. Over the Equivalently this myth says it would mergers is very much the way the longer term, as the investment be impossible to run down a CDC Dutch pension landscape has been policy becomes more defensive, this plan fairly — bizarre to think that we transformed over the past decade, change could well suit the remaining are concerned about the ending with the number of schemes moving members of the plan, who will be of these plans, when we have not from thousands, down to a much ageing alongside the plan itself. yet witnessed their beginning! smaller number — a few hundred — of larger, better governed schemes. In And finally if any members do CDC plans work by sharing risks Australia, smaller DC schemes (‘super’ not want to remain in this closed across the members of the plan. schemes) have been encouraged out CDC plan, they will always have The smoothing mechanism means of existence by regulators for similar the opportunity to transfer out that individuals get more predictable reasons. In the UK we have seen calls into another arrangement of levels of income and are not prone for the merger of smaller DC schemes. their choice. We propose that all to sudden changes in their expected members will have the right to a pension as a result of fluctuations If the CDC plan is not merged, then transfer representing their fair share in the value of investment backing gradually the trustees will adjust of the assets of the plan — which the pension promise, and the cost the investment and bonus policy is owned entirely by the members of securing an income. Smoothing to become more secure with less themselves. Transfers out in this works best over longer time frames emphasis on risky assets. This will fashion would ensure that leaving and so benefits from an open scheme not be an overnight process — the members and those who remain with new members joining — but benefits will still be payable for are treated fairly and consistently. is this essential? How would a CDC many years in the future and so no plan be wound down in practice? immediate change is required.

Collective DC Mythbusters 1 “CDC plans are just with-profits reinvented. Myth 2. CDC is with-profits version 2.0.”

CDC plans do share many of the of CDC plans, we would have the The lessons to be learnt for CDC features of with-profits funds. entire informed pension industry plans are that projections are just Investment is undertaken on a able to ensure that plans are doing that — they are not a guarantee. Any collective basis, without the need for in practice what they have told their literature to members will make it member choice or intervention. In a members they would do. If this level clear that they are not entitled to CDC plan, investment would be by of public transparency had been any underlying guaranteed benefit trustees, acting purely in the interests available during the with-profits era, and will probably try to convey of plan members, on professional we believe that many of the ‘outliers’ some sense of the underlying advice. In the case of both with- would have been identified — insurers uncertainty of potential outcomes. profits and CDC plans, the underlying where the bonuses awarded were Benefit illustrations will focus on returns are smoothed out to give a inconsistent with the underlying incomes in retirement (rather than steady return to each generation. investment returns being generated. capital values) and will be expressed in ‘real’, inflation-adjusted, terms So if with-profits were seen to fail A second difference with CDC plans (rather than nominal benefits). (and we can ask if they did), are is that we support a governance Both of these features should give CDC plans simply doomed to repeat structure involving a board of less volatile results, which can their failures? We think not. One trustees whose sole objective is to progressively adapt to changes in the key difference is that we propose support the interests of members. underlying economic circumstances. an exceptionally transparent and This provides a separation from open approach to the regulation the management of investments The Bill talks about requiring of CDC plans — all relevant with clear lines of accountability trustees of a CDC plan to set financial information would be in — something that has not always targets in relation to any collective the public domain, ideally on a been evident in with-profits funds. benefits — where they define publically accessible CDC website. target as “a target, relating to the Clause 34 of the Bill talks about Another complaint laid at the feet rate or amount of a benefit that is Regulations for CDC plans that of the with-profits history is that the unenforceable”. Trustees are asked may impose requirements about returns delivered were not those to focus on the probabilities of the publication of any document ‘promised’ to members. In this sense, meeting those targets and having relating to the plan. This information with-profits funds were no different a policy for dealing with ‘deficits’ could include all actuarial reviews, to conventional DC plans — benefit or ‘surpluses’ in relation to meeting all investment reports, all stress projections given to members were these targets, and an explanation of testing and details of how bonus overly optimistic with the benefit of the effect of their policy on members decisions had been arrived at. hindsight. DC statutory projections in different circumstances. The in the 1980s and 1990s were based conceptual framework is thus well We do not believe that individual on rates of return of up to 13% per established in the legislation, and members would be interested annum — surely this was blatant miss- will need careful communication to enough (nor in general selling? It is important to remember members, to ensure they appreciate knowledgeable enough) to review the context — during these decades, the difference between targets this material — but we do expect the equities had given returns of over and guarantees, which was a key wider pensions community, including 20% per annum for extended periods issue in the with-profits debate. the current ‘knockers’ of CDC, to of time — a common complaint study this information with interest. at the time was that 13% per So as well as having a Pensions annum was excessively cautious! Regulator looking over the finances

Collective DC Mythbusters 2 “Employers will fear retrospective changes in Myth 3. legislation, imposing DB style obligations on them from CDC plans. CDC won’t be supported by employers who won’t take on guarantees / extra costs.”

This has been a concern from the We believe that CDC plans should very first days of consideration of operate on the basis of a licence CDC plans and one we believe from the Pensions Regulator — and can be adequately addressed in the face of that licence will state the legislation. The concern is categorically that the employer that sponsors will be reluctant has no liability to pay any further to establish CDC plans because amounts to the scheme other than they fear that, at some unspecified contributions already paid. This is future date, legislation governing analogous to the way in which a them will become progressively limited liability company receives a tightened or amended and certificate of its limited nature from convert them to something more Companies House. In other words, onerous than anticipated. there is already a statutory precedent for an Act of Parliament providing Sponsors cite the legislation for a statutory limitation of liability. covering defined benefit schemes This should address the concern that — for example, the obligation to under English law, a government provide benefits to early leavers, cannot bind its successors — but to provide inflation protection to it can make them stop and think benefits in payment, to indexation before going against an express and revaluation of early leavers’ provision of previous legislation. benefits, pension protection fund levies and so forth. The second level of control for employers would be the equivalent We have worked with leading of a ‘Big Red Button’ in the plan pension lawyers to help the DWP documentation. The trust deed address this concern both in the and rules would contain a provision legislation and in the CDC plan for the automatic conversion of all documentation. The introduction benefits back into money purchase to CDC in the DWP response to the benefits immediately before any defined ambition consultation states: future legislation might take effect “A key feature for a CDC scheme which would result in any increase is that it provides certainty for the in employer liability in relation to employer who pays a fixed rate of the scheme. If such a clause were contributions and has no liability triggered then the scheme would to the scheme… and no balance- automatically move from being a sheet risk.” This strong statement CDC plan to being a conventional DC of principle needs to be followed plan, with each member receiving through into the detailed legislation. a fair share of the assets available.

Collective DC Mythbusters 3 “CDC plans will not get the scale they require. Myth 4. CDC will compete with good quality master trusts.”

As above we believe that CDC plans will work best where there are larger numbers of members, so that costs and risks can be shared across a broad group of members. As such we can see three routes under which these plans will develop:

• An individual larger employer, • Mastertrust arrangements — this who will have the size of is where an individual employer membership to make this type of any size joins with a number of of plan feasible — this might be other non-associated employers a few thousand employees. This in a collective scheme. Provided group might include employers the governance arrangements are wishing to make the move away consistent with emerging best from conventional DB schemes, practice in the conventional DC but who do not want to transfer Mastertrust arena, we believe this all of the responsibility for decision will be a very attractive route for making to members, in a way that employers, who want to avoid conventional DC schemes do. the overhead of setting up their own plans — and also want a sense • Industry wide plans — where of distance from the underlying again there could be more desire pension, for fear of changes in to support members, and less legislation, as in Myth 3 above. perceived benefit from having an individual plan. The experience in Holland and Australia has been that these larger, industry wide plans have significant appeal to both employers and employees alike.

Collective DC Mythbusters 4 “Flexibilities announced in the Chancellor’s Budget Myth 5. make CDC obsolete. CDC operates to individual Scheme Rules and runs contrary to the new pension freedoms.”

The 2014 Budget stopped the At the other end of the income scale, market innovation to fill this need, ‘requirement’ to purchase an people with very large DC pots with guaranteed products, with- annuity. Technically, it has not been will probably roll over out of their profits annuities, variable annuities a requirement for a long time, but it employer’s plan to a SIPP or other and newer strategies all coming into has been the only effective option, decumulation strategy offered by play. CDC has a role to play here. and a powerful default option, for their adviser or other intermediary. most retiring DC members. But They will value the new found Some employers will take the view the Budget has not taken away flexibility and can incorporate it into that their role in pension savings the need for a large number of a personalised financial planning is simply to contribute — what people to generate an income strategy that will continue throughout individuals choose to do with their from their DC pension savings, and their retirement. And no doubt, retirement savings is no concern CDC has a key role to play here. many will use the cash — perhaps of theirs. Others will see that drawn out over a number of years their role is to help individuals For many people, the Budget to manage their tax liability — to to generate a stream of income flexibility will give them an be able to purchase that buy-to- in retirement — we could call opportunity to ‘cash out’ at let property. The British obsession that a pension! This is more than retirement. This will typically be with property will be back with paternalism — it is recognising that individuals at both ends of the income a vengeance, accompanied by all it suits employers if their employees scale. For people on low incomes, its downsides, such as illiquidity can retire in an orderly fashion. with relatively small savings pots, their and concentration of risk. best strategy will almost certainly be Employers set up pensions today to cash out their savings and to spend As ever, the true need for pensions because they can do a lot of the it in a relatively short time. These will centre around the ‘squeezed thinking for individuals, and arrange people are protected from poverty middle’. These individuals will want matters better on a group basis in retirement by their reliance on to use their retirement savings than an individual basis. That is why the enhanced Single State Pension to generate an income to live in they negotiate better investment — now set above the means testing retirement — but they will also want solutions on behalf of members, threshold. Pensions savings will make to use some of the Budget flexibilities and why some of them will look very little difference to their standard to cope with life after they retire. They to put in place better retirement of living in retirement, and is a way could use part of their DC savings income solutions for members. of accumulating a lump sum that can to buy an annuity — but many will Market innovation will undoubtedly be spent fairly soon after retirement. not, or will defer this until much give rise to multiple decumulation later in life, e.g. at age 85 to provide approaches. A CDC plan deals not some long-term insurance against just with the investment process — outliving their savings. There will more effective on a collective basis be a need for some form of income than an individual basis — but it also generating solution from DC pots takes away what will become an to replace annuity purchase — and increasingly complex decision-making we can expect a proliferation of role in relation to decumulation.

Collective DC Mythbusters 5 We can envisage that CDC will form part of a core retirement income delivered by an employer. Consider the changing income needs of a pensioner, and how individuals will meet those needs — the diagram below sets out what we expect to be a typical strategy. Pensions Repay Freedom On top of the newly enriched Single mortage Travel State Pension will sit a CDC ‘core’ Help Care — paid for by the employer, with no children costs cash option, and with contributions of say 8% of pay. Individuals can Part time work ax free cash T save more themselves — perhaps even matched by their employer. Secure ation and income sources income These individual savings will be highly tax efficient: tax relief on the Expect way in, tax free roll up, tax free out State pension (up to 25% of total pension value, including employer contributions) Period of retirement with full unfettered access to the remainder of their DC pot, after the Budget. The Budget flexibility means that individuals can address their variable, changing needs in retirement, with the security of a basic retirement income from the CDC core and their state pension.

Collective DC Mythbusters 6 “The figure of 30% higher outcomes is just pie in the Myth 6. sky. CDC plans will not outperform always by 30%.”

Correct — CDC will not always The modelling that led to our 30% outperform and we have never figure was based on conditions prior asserted that. What we have said to the 2014 Budget, and assumed that is that ‘on average’ retirement individuals would opt to purchase outcomes from CDC plans will be an annuity with their pension pot on higher than conventional DC plans retirement. Is this comparison still where individuals annuitise on valid after the Budget freedoms? Of retirement. CDC outcomes are more course, we cannot predict what will predictable. That is the inherent become a typical or normal decision smoothing nature of the plan’s to convert a retirement pot into an design. If you were lucky enough to income — including cases where have retired from a DC scheme at individuals take their pension pot the end of the 1990’s after a huge as a cash lump sum; they still have stock market rally and when interest to generate an income to live off. rates were still reasonable, you would It seems reasonable to assume that have done better than under a DC individuals will invest in a higher plan. But if you retire today, when the proportion of return seeking assets market has not yet attained pre-crash than conventional annuities. Even levels, and when annuity rates are at though this comes with the risk of the lowest they have ever been, you an individual outliving their savings, would not do so well. To do well in a or being forced to liquidate at times DC scheme, you need to be able to of market dips, we should assume choose when to retire, and how to superior returns — which might cash out. CDC smoothes out market reduce the advantage offered by fluctuations and delivers a higher — CDC plans, but will not eliminate it on average — more stable outcome, altogether. A reasonable comparison where members do not have to take for, as yet, unspecified post Budget investment and retirement decisions. income solutions would be that the CDC 30% advantage will be reduced to say 15–20%. However, a key difference is that in a CDC plan, longevity risks are pooled, while in a DC plan they are, of necessity, borne by the individual. Collective arrangements offer superior solutions.

Collective DC Mythbusters 7 “CDC plans can’t be good because they are based Myth 7. on Dutch plans, and Dutch plans have cut pensions in payment.”

Please — can we stop going on about So how have the corresponding arrangements, respondents felt that the terrible cuts to the Dutch system! members fared under the present UK falls of 5 (or even 10) per cent could The Dutch Regulator showed that on system? Those fortunate enough to be manageable — particularly if the average for those schemes that had have retired from an open DB scheme fall was being faced by all members cut benefits in 2012 the cuts were — around 1.5 million out of a private Because of the assumption that, around 1.9%. So that’s not a cut of sector workforce of over 20 million — on average, Collective Defined 50% in their regular pension — but a will have received their full benefits, Contribution would provide a higher drop from €1000 per month to just plus inflation proofing. If their income in retirement in the first €981 per month. True, this is less than employer had gone bust, then their place, the possibility of an annual fall the inflation-linked increase members benefit would have been reduced was felt to be worth accepting.” may have been expecting — to on entry to the PPF — by perhaps around €1020 per month. But these 10% on a permanent basis plus likely cuts have been restored in a number lower (or no) increases in future. And of Dutch CDC plans, as markets have what of DC members who have been improved across 2013 and 2014. Part unfortunate enough to have bought of the Dutch system is that restoring annuities in the past five years? They pension cuts can have the highest are locked into those rates forever priority from improved conditions, — rates that are about 30% lower if benefits have needed to be cut. than annuity rates five years ago. And as a technical point, what the Dutch call CDC plans have only been So perhaps a fairer assessment of the around for a relatively short period ‘terrible’ Dutch cuts is that they have of time — most of these benefit cuts been a temporary 1.9% reduction have taken place in what they call versus a permanent 30% for UK DC Defined Benefit plans! Dutch DB plans annuity purchasers? The Institute of can reduce benefits to help restore Public Policy Research (IPPR) tested funding, in certain circumstances in the concept of benefit cuts with the Dutch system. Ironically, the true real individuals, via some in-depth CDC plans have been in existence for focus groups. Their conclusion, a relatively short period of time, and based on these conversations was: few have had to reduce benefits in “The fact that retirement income payment. The Dutch system — and could fluctuate in a collective scheme their nomenclature — is different was cause for concern. However, if to ours: we should not look to the scheme was run by a non-profit copy it, but we can learn from it! organisation with proper governance

Collective DC Mythbusters 8 “Individual accounts are part of the British Myth 8. culture. CDC only works in a highly unionised environment.”

This argument is that we can only Respondents felt protected against launch a Dutch style system — or responsibility for their individual is that a Danish style system? — if pensions, and several voiced the we adopt the entire characteristics idea that pensions should be a ‘social of that country. Now this might policy’, and that a collective scheme work if we tried to copy the Dutch was a more appropriate vehicle for at football — but it hardly seems it. The responsibility involved in sensible in relation to pensions. Apart the annuity process was universally from anything else, what about the disliked: respondents felt they had other countries around the world to make a decision they weren’t that have adopted CDC style plans adequately equipped to make, which — such as Canada? Do we have would be time-consuming and to adopt their characteristics too? troublesome, and would have a big What is a Dutch/Danish/Canadian impact on the rest of their lives. culture like? And heaven forfend that even the Americans have proposed There was a great fear of ‘getting legislation that would launch CDC it wrong’, and concern about style plans in the land of the free! the administration involved in The fact is that CDC plans have been making a decision. And remember adopted in a variety of different that post Budget, the range of jurisdictions and different cultures, retirement options will become as ways to improve retirement bewilderingly large — way beyond outcomes for members. We can pick simply choosing an annuity. the best from these and apply it in The IPPR research mentioned our culture and our jurisdiction. above came to the conclusion that

Interestingly, the Institute of Public there would be public support Policy Research carried out some for a collective style system: in-depth interviews with individuals “There is public appetite for a about their attitudes towards form of defined-ambition pension retirement saving and the concept that minimises some of the risks of collective schemes. Rather associated with Defined Contribution. than the individualistic approach In particular, participants in our suggested in this myth, many research preferred a Dutch-style people preferred the concept of collective scheme that shares the risk a collective arrangement. Several among all members and removes respondents said that they liked the the need for an annuity, and that solidarity of a collective scheme — incorporates some form of smoothing meaning they didn’t face the fear of into the accumulation phase.” making the ‘right’ decision alone.

Collective DC Mythbusters 9 “Companies do not want more choice. Companies Myth 9. want clear design and defined cost. The market will not innovate until there is clear demand.”

Employers may not want more choice We agree whole-heartedly that — but after the Budget that is exactly employers want a defined cost — what they have, in spades. There will that is why CDC has no underlying be a multiplicity of post retirement guarantees. Our strongly held ‘solutions’ in the market place, to view is that employers will not replace annuities — what will be right be prepared to tolerate any for their members? At a fundamental balance sheet or P&L exposure level, companies will have to decide from Defined Benefit schemes. if they want to get involved in this aspect of pensions savings. Some will The market will not innovate no doubt decide that if they deliver until there is a demand? Isn’t this a cash lump sum on retirement, then chicken and egg? Until we know how the member chooses to spend there is a better way to organise it is none of the company’s business. DC arrangements, why would Others may conclude they would employers ask for it? Did anybody like members to have an income ask for an iPod before they had in retirement, at least with part of been invented? What we can ask their overall retirement savings. is whether employers would be interested in a pension system that These companies will need to decide gave better, more stable outcomes how they will support members in to their members, at no additional converting capital into income. CDC risk to themselves? Would there be plans do this automatically and may a clear demand for this product? well appeal to employers, for all or part of their workforce, and for all or part of the retirement savings.

Collective DC Mythbusters 10 “CDC plans are just a job creation scheme Myth 10. for actuaries.”

It’s a fair cop! CDC plans do have jobs for actuaries, the number of an actuarial control process at their jobs will be fairly small — certainly hearts, to ensure the fair distribution significantly lower than the number of of returns among generations of Scheme Actuaries for existing defined participants. But unfortunately there benefit schemes. So yes, the cunning will not be very many of these plans! job creation scheme for actuaries As we have said above, CDC plans has been rumbled — but it wasn’t need scale to operate effectively — exactly a seismic shift in long-term so while we may have created some actuarial employment prospects!

Collective DC Mythbusters 11 Contacts

Chintan Gandhi +44 (0)1372 733 322 [email protected]

Matthew Arends +44 (0)20 7086 4261 [email protected]

David Hardern +44 (0)1727 888 640 [email protected]

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